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Pharma - Just What Dr Income Ordered!

HL SELECT UK INCOME SHARES

Pharma - Just What Dr Income Ordered!

Managers' thoughts

Important information - The value of this fund can still fall so you could get back less than you invested, especially over the short term. The information shown is not personal advice and the information about individual companies represents our view as managers of the fund. It is not a personal recommendation to invest in a particular company. If you are at all unsure of the suitability of an investment for your circumstances please contact us for personal advice. The HL Select Funds are managed by our sister company HL Fund Managers Ltd.
Steve Clayton

Steve Clayton - Fund Manager

31 March 2017

Over 8% of the HL Select UK Income Shares portfolio is invested in Pharmaceutical shares, and if we included the big slice of Reckitt Benckiser’s earnings that come from consumer healthcare products, then over 10% of the fund is invested in healthcare related businesses.

For income investors, one of the attractions of healthcare is the stability of demand. A very large number of people are poorly, one way or another, all of the time. That means well managed healthcare businesses can have predictable earnings, which can then lead to reliable dividends. Nothing of course is guaranteed, and healthcare companies are perfectly adept at catching diseases all of their own.

Our largest exposure in the sector is GlaxoSmithkline (4.4% weight) and the stock where we see the largest potential upside is AstraZeneca (3.8% weight). That may seem contradictory, but there is method behind our madness, and not vice versa.

Patents and prices

One of the diseases that pharmaceutical companies can catch from time to time is Expiry-itis. When drugs they discovered years ago reach the end of their patents, competitors can start selling the same molecules as so-called generic drugs, for a fraction of the original drug’s selling price. Inevitably, the original manufacturer has to cut their own selling price yet still loses a big slice of volumes to the new competitors.

GlaxoSmithkline has been suffering from Expiry-itis for some time and now looks to be recovering, with just one major patent expiry, for its respiratory drug Advair, left to hit. The group’s pharmaceutical business looks stronger as a result. With a solid Vaccines business, a large Consumer Healthcare operation, selling brands ranging from Nicotinell to Sensodyne, plus a stake in ViiV, the world’s leading HIV therapy business too, the overall prospects look encouraging and we expect the group to be capable of growing its dividend steadily. Given a starting yield of about 4.8%, that’s a useful contribution to the fund’s overall income although this is not a reliable indication of future income.

AstraZeneca’s case of Expiry-itis has been pretty severe of late, with a big swathe of former blockbuster products losing their patents, putting earnings under pressure. The company has responded by realising value through selling off stakes in some of their research programmes, or disposing of smaller products altogether for cash. That has allowed it to keep paying an attractive level of dividend, but this process can only go on for so long.

What’s in the pipeline?

For a bright future, AstraZeneca needs new blockbusters, and here the pipeline of new candidates coming out of the lab looks exciting. Drugs can’t go to market until approved by regulators and key decisions will be taken by the US FDA on major new products for AstraZeneca in the coming year or so. If the drugs prove themselves in clinical trials, then AstraZeneca will have a clutch of new treatments that could improve outcomes for millions of sufferers of chronic and often terminal diseases ranging from lung cancer to respiratory and heart conditions.

Success could see billions of dollars a year of new, likely high margin sales from these products. But should drugs like Durvalumab or Tagrisso fail their final trials, then AstraZeneca could face difficulties. It is this downside risk that stops us from taking as big an exposure as we might otherwise wish. GlaxoSmithkline’s potential returns may not be as high, but they seem to come at a lower level of risk. If our confidence in AstraZeneca’s pipeline of new drugs improves, we could add to the position, and vice versa.

Throughout the fund, we make these risk and reward assessments and adjust weightings accordingly. We only hold stocks that we think have great potential to contribute to our investors returns. But, as Orwell might have put it, in the HL Select UK Income Shares fund, all stocks are equal, but some are more equal than others.

Other news:

We had a great meeting with the management of BCA Marketplace, a smaller company that we hold in both the HL Select UK Shares and the UK Income Shares funds. They own the dominant Car Auction business in the UK, (along with the less annoying than it used to be) WeBuyAnyCar.com consumer car buying company. Prospects look strong, with a big rise expected in vehicles coming to auction as cars originally bought under PCP plans come to the end of their finance plan. We believe competitor advertising, challenging WeBuyAnyCar is if anything having the opposite effect.

Little capital is required in the core Auctions business, meaning that growth in profits should translate strongly into growth in dividends. At the current level, the stock could be yielding over 4% in FY18, and growing nicely although this is not guaranteed. Imminent changes to vehicle duty might cause a blip up, then down in new car sales, but BCA tends not to see cars until they are a few years old, by which time it should all have calmed down. Few businesses have a core asset as dominant as British Car Auctions and we remain very happy with our exposure to the company.

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Important - This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information. Unless otherwise stated performance figures are from Bloomberg and estimates, including prospective yields, are a consensus of analyst forecasts from Bloomberg. They are not a reliable indicator of future performance. Yields are variable and not guaranteed.